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4% rule and taxes
Old 07-11-2009, 10:16 AM   #1
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4% rule and taxes

Most of the articles I read never mention taxes and obviously that has a large impact. I have seen examples of the 4% rule for $1M. This would let you withdraw $40,000 the first year. However if the $1M earned 5% interest and gains, then you have to pay taxes on $50K. Does the taxes come out of the nestegg or the $40K withdrawal? I really have trouble figuring out what the tax hit will be once I am in retirement. I think I have a good handle on my expenses. Fire, ING what's your number, etc all yield largely different numbers.
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Old 07-11-2009, 10:27 AM   #2
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The 4% rule has nothing to do with taxes, only the amount you can theoretically withdraw from your portfolio the first year (you can increase for inflation in following years) and not run out of money for 30 years.

In your example, if you are withdrawing $40,000/4% from tax deferred savings, a traditional IRA for example, then you would be expected to pay taxes from that amount, reducing the $40,000 to some smaller number you could actually spend. If you paid your taxes on the $40K by withdrawing additional funds from your IRA, then you would be exceeding 4% and theoretically place your nest egg at risk of depletion.

If your $1M was in a traditional IRA and earned 5% that year, you'd owe no taxes on the $50,000 earnings as you only pay taxes on what you withdraw. If your $1M was in a taxable account and you followed the 4% rule, you'd need to pay the taxes on your $50,000 earnings out of your $40,000 withdrawal amount...
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Old 07-11-2009, 10:33 AM   #3
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If you are paying out of a taxable account, you have to pay tax on 50000. Say you are in a 10% bracket. That means you have 35000 to use after tax. The other 10k stays in your account...otherwise your WR is higher than 4%. If you are in the same 10% bracket and pull 40000 out of your IRA or 401k, then you have 36000 left to spend. The rest stays in the IRA, growing and untaxable, until you pull it out.

Make sense?

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Old 07-11-2009, 11:02 AM   #4
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Originally Posted by GaryK View Post
Most of the articles I read never mention taxes and obviously that has a large impact. I have seen examples of the 4% rule for $1M. This would let you withdraw $40,000 the first year. However if the $1M earned 5% interest and gains, then you have to pay taxes on $50K. Does the taxes come out of the nestegg or the $40K withdrawal? I really have trouble figuring out what the tax hit will be once I am in retirement. I think I have a good handle on my expenses. Fire, ING what's your number, etc all yield largely different numbers.
Usually when people calculate their need for retirement income, it's stated as pre-tax, with the assumption that you deduct taxes from that amount.

One of the reasons it's done this way is because tax circumstances can vary widely based on your ultimate tax bracket in retirement, state income tax considerations, tax filing status, age (whether or not over 65), whether or not some of your SS is taxable (and whether it's 50% or 85%), whether IRA withdrawals are from a conventional or a Roth, and so on.

There's no real way an article or a general retirement calculator can do all the scenarios justice, so the default is to "punt" on the tax question and just have people estimate their pretax needs based on the tax scenario they think is most likely for them in retirement.
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Old 07-11-2009, 11:15 AM   #5
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In other words, Gary, treat taxes like any other expense.
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Old 07-11-2009, 11:46 AM   #6
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Originally Posted by Rich_in_Tampa View Post
In other words, Gary, treat taxes like any other expense.

What Rich said. All taxes, income, property, sales etc are just another expense for the sucker, over-taxed citizen, lucky retired citizen to be able to contribute to the betterment of all of society.
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Old 07-11-2009, 02:52 PM   #7
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Thanks for the feedback. I will have to find a way to estimate my net after taxes in order to feel comfortable with my savings.
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Old 07-11-2009, 02:54 PM   #8
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Thanks for the feedback. I will have to find a way to estimate my net after taxes in order to feel comfortable with my savings.
Yes, you do.

OTOH, when you are withdrawing after-tax dollars, you can back out the tax "expense." Main thing is to be aware of it in your planning, and that you usually will be in a lower bracket in retirement than you were before.
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